Description

North West Company Fund represents the best way to invest in the “gold rush” occurring in Canada for oil, natural gas, zinc, copper, tungsten, uranium, etc. North West Company Fund operates retail, discount merchandise and convenience stores in Northern Canada and Alaska. Formerly the well known Hudson’s Bay Trading Company that started in 1779, North West is primed to benefit from the surge of workers, people and investment flooding into the remote regions in Canada. North West is an income fund that is only paying about 50% of distributable cash flow, yet still yields close to 6%. It is reinvesting the rest of the cash flow into growing its retail presence in Western Canada. With double digit earnings growth probable for the next three to five years, North West represents substantial value at 12 times my 2006 conservative earnings estimate, especially considering they don’t really pay taxes (Income trusts don’t pay taxes, though the Alaskan subsidiary does pay taxes). With more recognition, analyst coverage and continued solid results, North West should increase to at least C$60 a share, in addition to its excellent 6% yield. In two years, North West could see C$100 a share.

The New Hudson Bay Trading Company

From the company’s website:

“The North West Company can trace its roots back to the first trading post in North America, established at Waskaganish (formerly named Rupert's House) on the shores of James Bay in 1668; there is a Northern store operating there today! NWC continues to diversify, flourish and grow from the original Montreal-based partnership of traders in 1779.

Throughout the 1800's until 1987, NWC has changed hands, names and not surprisingly, the services it provides. 1821 brought the amalgamation of the North West Company and Hudson's Bay Company, under the HBC name, creating a fur trading monopoly that covered one-quarter of North America. The enterprise continued as the Fur Trade Department, and then the Northern Stores Division, of Hudson's Bay Company. In 1987, the Northern Stores Division was acquired by a group of investors including 415 employees.”

Today there are 190 retail outlets, located in British Columbia, the Yukon Territory, the Northwest Territories, Alberta, Saskatchewan, Manitoba, Ontario, Nunavut, Quebec and Labrador, operating as Northern, NorthMart, Quickstop and Giant Tiger. Alaskan operations include 26 stores, operating as AC Value Centers and one AC Quickstop.

There are 132 Northern stores. Northern is a combination food and general merchandise store format located in remote, northern Canadian communities. Northern stores serve communities that have no more than 5,000 people, to give you an idea of who exactly they serve. Many of these towns are in very remote places, many with high barriers to entry.

There are 27 AC Value Centers, which again is a combination food and general merchandise store format serving communities throughout rural Alaska. There are 10 NorthMart stores, which target larger, regional markets and offer an expanded selection of fashion merchandise and fresh food. There are 7 Quickstop convenience stores which offer prepared foods, and petroleum products.

There are 14 Giant Tiger stores. Giant Tiger is a junior sized discount store format offering family fashion, household products and food at convenient locations. The stores are operated under a master franchise agreement.

Besides those stores, North West sends out more than 250,000 copies of its Selections catalogue. This catalogue is distributed across northern Canada and features everything from fashion and snowmobiles to computers and boats.

Frontier Expeditors is a distributor of food and general merchandise to independent grocery stores in rural Alaska. Crescent Multi Foods is a distributor of produce and fresh meats to independent grocery stores in Saskatchewan, Manitoba and north-west Ontario.

Finally, North West offers Canadian heritage products, Native American art in various outlets (this is a very minor portion of their business).

Modernization Effort

This company was a sleepy retailer barely growing sales, but was quite profitable for several years. Things have started to change but not just because of macro factors; North West has been modernizing.

In the past three years, North West has undergone a substantial modernization of its operations that include investment of store technology, training, and distribution. Besides a brand new in-store information system, North West has rolled out a broadband communication network to all of the Canadian stores, so that inventory and sales are maximized. This roll-out is important due to the remoteness of many of these stores.

Another modernization example is the implementation of a new centralized pricing system and working to lower costs. North West also centralized its meat procurement and distribution for Western Canada and moved to a new expanded facility for food distribution.

The bulk of this modernization effort has been completed and it is showing up in profitability measures and enhanced sales growth. As proof, operating margin increased in the last fiscal quarter ending October 29th (despite dramatically higher fuel costs), to 7.9% from 7.7% a year earlier. Consider that the best retailer on the planet, Wal-mart, has 5.9% margins. Not only have margins been increasing but they are very high already.

The Boom Times in Canada

The key consideration for this investment is how North West is going to benefit from the boom times going on in Canada. Canada and especially western and remote regions of Canada are benefiting from a surge of money, interest, drilling and exploration for oil, natural gas, nickel, copper, zinc, tungsten, uranium, etc. Canada is filled with natural resources. As companies and the government spend money on exploration and infrastructure, workers are getting paid more, and people are moving to these remote locations to earn outsized salaries. This should directly benefit North West.

60 Minutes did a segment on the Canadian oil sands and the boom time of Fort McMurray in early January. There were several very fascinating tidbits in this segment. Fort McMurray has doubled in size in five years to around 60,000 people. The mayor of the town said that in the next decade they may need another 150,000 workers. If that’s not shocking enough, truck drivers there earn $120,000 a year. I believe North West Company Fund is the perfect investment to capture this explosion in workers, income and demographic change.

Who Are their Customers?

The largest customer group for North West derives most of its income from government assistance in some form. The major source of employment income is generated from governmental spending on infrastructure projects. It is very important to note that Canada is flush with cash and is running large fiscal surpluses. The government is starting to increase infrastructure spending to enable larger economic and commodity development in the country. This North West customer group should directly benefit from all the government money spent and from companies which are building out infrastructure and mining projects.

On the flip side, this customer may equally be hit by an economic slowdown or by increases in fuel prices harder than other groups. Over the long run this group should benefit by the long run macro changes in Canada.

Boring Sales Growth until 2004

Sales growth for North West was anemic in 2003 with only 2.3% total sales growth once you exclude an extra week the company possessed in fiscal 2003. But in 2004, sales growth slowly started to change, with sales in q1 creeping to 2.8%, then to 3.2% in q3, and ending the year with a 4.5% gain (adjusted due to the lack of a week).

In 2005, the trend became quite clear, with q1 sales up 6.4%, q2 sales up 8.9% and in q3 sales up 7.3%. The third quarter sales would have grown close 10% if it wasn’t for the strong Canadian dollar.

This trend in sales is due to four things. The first is the above mentioned boom that is starting to happen in Canada. The second is the modernization program the company has implemented that has enabled them to more effectively manage inventory and sales. Thirdly, the company’s bet to expand food distribution is paying off handsomely.

But the biggest reason for the surge in sales is the success of the Giant Tiger stores and the expansion of those stores.

Giant Tiger

Think of these Giant Tiger stores as mini-Walmarts for small Canadian communities such as Prince Albert, Saskatchewan. Giant Tiger is a discount retailer of food and merchandise including clothes. The company has been ramping up the number of these stores, and by the end of 2006, there should be 20 stores.

These stores are having a big impact on North West. Giant Tiger sales for 2004 grew 60.5% to C$75.8 million. Giant Tiger is now up to 12% of total sales for North West up from 7.7% in 2003. I expect that by the end of 2006, these stores will be on a run-rate of close to 20%.

These stores cost about C$700-C$800K in capital expenditures to open and cost a lot to ramp up to breakeven. So, there is a natural drag on earnings as the company opens these stores. Initially, these stores have a strong tilt towards food sales, close to 70% to 30% food to general merchandise. Then as the stores move into the second and third year, the stores move towards 50/50. Food clearly has lower margins and this is initially dragging down the margins of the entire company.

But Giant Tiger is where the growth is, especially as the company expands into Western Canada, where it has little in the way of competition. Same store sales are growing in the high single digits for Giant Tiger stores already open. And as the stores mature the customers start shopping at Giant Tiger for more merchandise. So, the sales growth turns into a higher margin business.

This is the key to the company eventually getting a premium multiple. If Giant Tiger grows at high single digit comps for all of its stores, they keep opening 4-5 stores a year, and the trends towards more merchandise keeps improving, earnings could blow away expectations in 2006-2008.

Food Distribution

North West is growing their food distribution business both in Alaska and in Canada because they see opportunity. If more people are moving to Western Canada and there is a large demographic shift, there is a real growth opportunity in food and particularly meat distribution. Especially considering that many of these places are remote.

As an example, all of North West’s Canadian food sales were up 9.7%, and were up 5.6% on same store basis. And in Alaska at their Frontier Expeditor wholesale business, food sales were up 10.8% reflecting new account growth.

Simply with higher incomes and good demographics this is a good business to be in.

Key point on Alaska that specifically benefits q4

Every Alaska citizen gets paid for living there. These checks are called Permanent Fund Dividend checks (PFDs). These checks are normally sent in the third quarter, which is when the checks were received last year. Due to timing issues they were sent in the fiscal fourth quarter instead. This depressed North West’s Alaskan results in the third quarter.

But November sales were up almost 19% for North West’s Alaskan operations so there should be a nice benefit to q4 from this timing issue.

Another key point benefiting q4 and 2006 is the 15,000 square foot store they acquired from a competitor in October that is going to be converted into a large format convenience store. This should be a boost for the Alaskan business as well.

Return on Assets and Equity are excellent

North West shines on return on net asset and equity measures. Return on net assets is increasing and in 2004 it was nearly 15% (2005 should be just as good). Return on equity is also increasing and is over 16%.

And this great performance has not come from an increase in leverage as net debt to equity was a low 0.49 to 1, compared to 2000’s debt to equity ratio of 0.92 to 1.

Yield artificially low

North West currently pays a 6% yield but it could be much more if they reallocated away from their growth. That said, they did announce a 14.9% increase in distributions for fiscal 2006 and I expect further increases in the future.

Another potential big win for unit-holders is that the company is petitioning for a restructuring in the way it is set up to reduce taxation and increase flows of funds to the unit-holders. If this occurs in early 2006 as expected, distributions will climb.

This Growth Stock is Extremely Cheap

North West should earn about C$2.80 in fiscal 2005, a 21% increase in EPS over fiscal 2004. Assuming conservative earnings growth of 12%, this would get me to 2006 earnings of C$3.14. Due to their little or no taxation, the best way to compare this to other retailers is to compare their valuation on a pre-tax basis. If we assume that the average retailer that is growing gets a 15 multiple and add 35% to that for the lack of taxes, we get a 20 multiple.

If I take my 2006 estimate and give it a 20 multiple, I get a valuation of C$63, a 67% increase over the current price. Add in the yield and this investment would return 73%. Add another 12% earnings for 2007 and you get a C$70 stock price, or an 88% increase. Add in the yield and you are close to a 100% return in 18 months to two years.

What would happen if the stock posted 15% to 20% earnings growth and received a premium multiple due to its excellent return on equity measures and above average profitability measures? I think there is a very good chance in 18 to 24 months this could be a C$100 stock.

But why is it so cheap? First, no one covers it. The company doesn’t need money or financing so it is being ignored by Canadian brokerages. As if to prove it, the last presentation available on the company is from January of 2004. Second, North West was one of the first companies to turn into a trust, so there is no catalyst or reason for brokers or investment bankers to cover it. It has been forgotten. Third, as an income trust, the company has a comparatively low yield. The artificially low yield causes investors to pass over the company as the yield is not compelling. But that mentality misses the company’s substantial growth prospects. Fourth, it has not really dawned on the investment community that the dynamics of the company has changed and that North West is now solidly growing.

I believe with exposure and continued excellent results, the valuation will change quickly.

Summary

This is an excellent opportunity to participate with the “gold rush” of people and money in Canada without the inherent volatility of the underlying commodities driving this “gold rush.” At an inexpensive 12 times earnings, investors get to participate right as sales and earnings are accelerating in a company with limited competition and with tremendous demographic and store expansion growth ahead of it. Investors in North West should easily double their money within 18 months.

Catalyst

1) Analyst Coverage
2) removal of cash tax expense
3) q4 earnings
4) increase in distribution
5) Opening of new Giant Tiger stores